The Flow of Funds and Interest Rates Determination Part Two

Which one of the following is the best explanation of loanable funds theory?

• The total amount of money corporations can borrow.

• The total amount of money households can lend.

• The market interest rate is determined by factors controlling the supply of and demand for loanable funds.

• The total amount of money in the market.

Answer explanation

The loanable funds theory, commonly used to explain interest rate movements, suggests

that the market interest rate is determined by factors controlling the supply of and

demand for loanable funds.

The theory is especially useful for explaining movements in the general level of interest rates for a particular country. Furthermore, it can be used (along with other concepts) to explain why interest rates among some debt securities of

a given country vary.

The source of the supply of loanable funds?

• is saving and the source of demand for loanable funds is an investment.

• is an investment and the source of demand for loanable funds is saving

• and the demand for loanable funds is saving

• and the demand for loanable funds is investment

If other things are constant, when the interest rate rises...

• people would want to lend more, making the supply of loanable funds increase.

• people would want to lend less, making the supply of loanable funds decrease.

• people would want to lend more, making the quantity of loanable funds supplied increase.

• people would want to lend less, making the quantity of loanable funds supplied decrease.

If there is a surplus of loanable funds...

• the quantity of loanable funds demanded is greater than the quantity of loanable funds supplied and the interest rate is above equilibrium.

• the quantity of loanable funds demanded is greater than the quantity of loanable funds supplied and the interest rate is below equilibrium.

• the quantity of loanable funds supplied is greater than the quantity of loanable funds demanded and the interest rate is above equilibrium.

• the quantity of loanable funds supplied is greater than the quantity of loanable funds demanded and the interest rate is below equilibrium

What would happen in the market for loanable funds if the government were to increase the tax on interest income?

• Interest rates would rise.

• Interest rates would be unaffected.

• Interest rates would fall.

• The effect on the interest rate is uncertain.

The slope of the supply of loanable funds curve represents?

• positive relation between the real interest rate and investment.

• positive relation between the real interest rate and saving.

• negative relation between the real interest rate and investment.

• negative relation between the real interest rate and saving.

Which of the following is NOT a factor in the determination of an interest rate?

• Economic Growth

• Inflation

• Monetary Policy

• Financial Assets

Answer explanation

Factors affecting interest rates are (1) economic growth, (2) inflation, (3) monetary policy, (4) budget deficit, and (5) Foreign flow.

When the central bank increases the money supply, it increases the supply of loanable funds and this places downward pressure on interest rates.

In contrast, if the central bank reduces the money supply, it reduces the supply of loanable funds. Assuming no change in demand, this action places upward pressure on interest rates.

• True

• False

Answer explanation

The central bank can affect the supply of loanable funds by increasing or reducing the total amount of deposits held at commercial banks or other depository institutions.

The term structure of interest rates is the relationship between interest rates and different terms or maturities. It also reflects the expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.

• True

• False

Yield curve is a graph illustrating the relationship, at a point in time, between interest rates (or yield) on identical security (e.g. government bonds) with different terms to maturity.

• True

• False